The Protecting Americans from Tax Hikes (PATH) Act, passed December 2015, made significant – and beneficial – changes to the federal research and development tax credit program. The changes are effective for 2016.
Businesses with qualified research expenses (QREs) are eligible for tax credits. The credits can directly reduce the tax of a C corporation. S corporations and partnerships pass the credit through to owners for use on their individual tax returns.
The R&D credit program was initially intended as a temporary program. Because of its popularity, whenever it expired, Congress extended it. The uncertainty caused by the recurring extensions was bad for the businesses who were using the credit.
The credit could not be used against alternative minimum tax (AMT). A business in AMT for the year couldn’t use the research and development credit. A business that wasn’t in AMT could use the credit against their regular tax liability, but only to the extent it exceeded the greater of: tentative AMT; or, 25% of the portion of regular tax in excess of $25,000.
Credits generated but not used can be carried back 1 year, and carried forward 20 years.
Caution: the definition of QREs and the mechanics of the credit are complex. Consult your tax adviser for further information.
R&D Tax Credit 2016 Changes
The R&D Credit is now Permanent
The research and development credit had expired at December 31, 2014. The PATH act retroactively restored the program for 2015, and permanently extended it. This is a big plus for businesses that rely on the credit in their tax planning.
Eligible small businesses can apply research credits to AMT liability
Beginning in 2016 the research and development credit of an eligible small business is not limited to the business’s tentative AMT.
Eligible small business
A taxpayer is an ESB for a particular tax year if its average gross receipts for the 3-year period preceding the current year does not exceed $50 million (the gross receipts test). But, note the following:
- A corporation whose stock is publicly traded is not an ESB regardless of its gross receipts
- S corporations and partnerships must meet the gross receipts test at both the entity level and the shareholder/partner level
- Gross receipts for short years must be annualized
- Certain related entities need to aggregate their gross receipts to determine if they qualify
ABC Company is an S corporation with 1 owner. ABC’s average gross receipts for 2013 – 2015 were $12 million. The owner has average gross receipts from other sources of $2 million. So, both the entity and the shareholders pass the gross receipts test.
ABC generates $50,000 of R&D credits in 2016 and passes them through to the owner on his K-1.
The owner has a net regular tax liability of $55,000 before applying the credits. He has tentative AMT of $30,000. 25% of his tax liability in excess of $25,000 is $7,500 ($55,000 – 25,000 = 30,000 X 25% = $7,500).
Under the old rules, the research and development credit would have been limited to the net regular tax liability of $55,000 less the greater of:
- Tentative AMT of $30,000
- 25% of his tax liability in excess of $25,000, which is $7,500
So, the amount of credit that could have been utilized was $25,000 ($55,000 regular tax less $30,000 tentative AMT), leaving a final tax liability of $30,000. The remaining $25,000 of credits would be carried back 1 year and carried forward 20 years.
Under the new rules, tentative AMT is treated as zero for this purpose, so the research and development credit is limited to the net regular tax liability of $55,000 less the greater of:
- Tentative AMT of $-0-
- 25% of his tax liability in excess of $25,000, which is $7,500
In this case the amount of credit that can have been utilized is $47,500 ($55,000 – $7,500), leaving a final tax liability of $7,500. The remaining $2,500 of credits are carried back 1 year and carried forward 20 years.
Some businesses can apply the credit to payroll taxes
A problem with the R&D credit is that businesses with no income tax liability don’t benefit from the credit. Under the 2015 PATH Act, a qualified small business (QSB – this is different from ESB above) can elect to apply a portion of their R&D taxes to the employer portion of Social Security taxes. So, businesses with no income tax liability still benefit.
Qualified small business (QSB)
A business is a QSB for a tax year if:
- Its gross receipts for the year are under $5 million (annualized for a short year), and
- The entity didn’t have any gross for any tax year before the 5-year period ending with the current tax year
- An organization exempt from taxation under Code Sec. 501 can’t be a QSB
- A taxpayer can’t make the election in more than 5 tax years.
How much credit can you use?
The amount of R&D credits that can be used against payroll tax is the least of:
- The research credit determined for the year,
- $250,000, or
- In the case of a QSB other than a partnership or S corporation (e.g. C corporation, sole proprietor), the amount of the business credit carryforward for the year (in other words, these taxpayers must first use their R&D credit against income tax liability (if any) for the current and prior year).
- Note that certain related taxpayers must allocate the $250,000 limitation.
Applying the R&D credit to payroll taxes
To apply the credit to payroll tax, the taxpayer must make an election on its income tax return. The election must specify the amount of credit to be applied to payroll tax, and the return must be filed on or before the due date, including extensions. The credit is allowed for the first calendar quarter which begins after the date the income tax return is filed.
The credit is applied against the employER’s portion of the OASDI (social security) tax paid. It cannot be applied against the employEE portion of the tax, or against any part of Medicare tax or any other payroll tax.
If the amount of credit exceeds the applicable tax for any quarter, it carries forward to the next quarter.
The employer can take a deduction for its share of OASDI tax calculated, even though the R&D credit was applied to it.
Tech Company is a C corporation formed to conduct research toward a new computer software application. It was formed in 2013. It had no gross receipts in 2013 or 2014. In 2015 it created a usable side product and had gross receipts of $200,000 in 2015 and $300,000 in 2016. Its research and development credit for 2016 is $40,000. It has no income tax liability for 2016. Tech has no related entities.
Tech has gross receipts under $5 million and no gross receipts prior to 2012. It has no income tax liability for 2016 and its R&D credit is under $250,000. Therefore, the entire credit of $80,000 can be elected.
Tech files its 2016 income tax return on March 10, 2017. Tech elects to apply the entire $40,000 credit to payroll taxes. The first quarter after it files its tax return is the second quarter of 2017, which begins April 1, 2017 and ends June 30, 2017. Tech’s payroll for that quarter is $240,000, and no employees are over the social security ceiling. So, the employer portion of OASDI tax is 6.2% of $240,000, or $14,880. Tech does not need to pay the $14,880. The remaining credit of $25,120 is carried forward to following quarters until it’s used. Note that even though Tech didn’t pay the $14,880, it can still take that as a deduction on its income tax return for 2017.
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